Big Changes Yet to Come from Basel III and Dodd-Frank
By: Jordan Angel, director with HFF in San Francisco
Winter 2016 2017
New regulations are constraining construction lending and testing the long-term viability of the CMBS market.
WHEN YOU COMPARE the first half of 2015 to the first half of 2016, commercial real estate lending volumes are flat at around $215 billion across all lender types. The composition of lenders has shifted in favor of banks and life insurance companies, which are up 38 and 9 percent, respectively, in large part because securitized lenders are down 77 percent year to date. CMBS and bank lenders face various new regulatory headwinds, including new Basel III rules related to high volatility commercial real estate (HVCRE) loans affecting banks and risk retention legislation affecting CMBS lenders. Borrowers continue to enjoy a historically low interest rate environment and significant liquidity from all types of lenders.
Commercial Mortgage Backed Securities: Regulation and Maturities
2016 has been a very interesting year for the CMBS market, and the biggest changes are yet to come. This year inherited a volatile market from the end of 2015, with spreads moving from deal to deal and the floating-rate securitized market lacking liquidity. While the floating-rate market continues to languish, the fixed-rate CMBS market is actively closing deals on some of the best terms for borrowers in a long time. Typical fully leveraged deals are locking in 10-year fixed rates as low as 4 percent.
Regulatory Change: Risk Retention Requirements. The most significant regulatory change in CMBS this year will be the risk retention requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which take effect on December 24, 2016. Risk retention requires that a securitization originator hold (or sell to a B buyer under specific circumstances) 5 percent of the loan pool it is selling for the life of the loans.
Market expectation is for a roughly 20 basis point increase in interest rate spreads attributed to the need to hold this 5 percent slice. This will likely cause smaller originators to leave the business, or at least give larger banks that can hold this illiquid security for 10 years a leg up. With implementation set for Christmas Eve, loans that were not closed and securitized by mid November will likely be subject to these new requirements, given the typical delay in securitization from closing. In mid-2016, securitized lenders such as Wells Fargo began to test various structures to comply with this new requirement.
Wall of Maturities. Starting in 2014, CMBS maturities have been steadily ramping up, with the greatest amount ($136 billion) coming due in 2017. It is important to keep in mind that the majority — more than 70 percent — of these loans are for less than $10 million and are coming off of higher rates in the 5 to 6 percent range. To date, the rise in property values, along with the very low interest rate environment, helped provide financing options for the loans that are coming due. A significant number of the loans that are maturing have already been paid off and refinanced — to capture long-term fixed-rate financing and cash out some equity prior to maturity — or sold.
Insurance Company Lenders: Business as Usual
With CMBS lenders sitting on the sidelines at various times in 2016, insurance companies became the dominant player in long-term fixed-rate financing. Given the low interest rate environment, many life company lenders have instituted interest rate floors in the 3.25 to 3.50 percent range for 10-year fixed rate money. Many were already hitting capacity for the year by the third quarter and had begun to focus on 2017 business.
Insurance companies continue to employ conservative underwriting standards, with a strong focus on reliable cash flow from creditworthy tenants on long-term leases. In higher cost markets such as San Francisco, insurance companies focus on their loan-per-square foot exposure in comparison to recession valuations and replacement cost. On low-leverage, high-quality real estate, 10-year fixed-rate loans are routinely being financed in the mid 3 percent range.
Banks: Construction Loan Headwinds
Large domestic banks continue to tighten underwriting standards while smaller and foreign banks are taking a larger share of the commercial real estate lending market. There has been a strong focus on loans that may fall into the HVCRE classification. As noted earlier, the Basel III standards now impose increased capital requirements on most banks for loans that finance the acquisition, development or construction (ADC) of a commercial property. Most banks are now required to hold 150 percent in reserve against an HVCRE loan, which is 50 percent higher than the reserves required for other types of loans.
Banks can avoid having to hold the additional reserves by meeting the following requirements:
1) Demonstrating that the developer has at least 15 percent of the project’s “as completed” appraised value in the deal prior to the bank funding.
2) Contractually requiring all contributed capital to remain throughout the project.
3) Maintaining a strict loan-to-value ratio of 80 percent for most property types.
Banks continue to try to understand the HVCRE regulations. During this implementation phase many banks are looking at transactions differently. For example, some banks view preferred equity and/or mezzanine debt as part of the debt stack, while others treat it as part of the equity stack. The HVCRE requirements, along with the fact that many of the larger domestic banks have already committed to all of the construction loan exposure they want on their books, has made finding construction financing very difficult and, for second-tier sponsors, next to impossible.
Selected For You
The Site Feasibility and Market Analysis course starts with an analysis of macro-economics that drive and support the demand for real estate development.
Help advance the NAIOP Research Foundation’s research agenda, which provides vital information to commercial real estate professionals.